How Do Standards Affect Litigation Risk?
By John McInnis
My research examines how investors and creditors use financial reporting information and how it affects managers’ reporting incentives. I’m constantly fascinated by standard-setting policy debate, and I really wanted to dive deep into the topic. I also teach financial accounting, so any research into standards helps to make me a better instructor.
One of my studies focuses on how accounting standards affect securities litigation. Specifically, we examined whether “rules-based” accounting standards increase or decrease litigation risk. Some argue clear guidance shields firms from litigation risk, while others argue that detailed prescriptions make it easier for plaintiffs to point to mistakes and allege fraud. So we decided to see who made the better case. For every standard in U.S. GAAP, we determined the extent to which it contained “rules-based” characteristics. These are things like bright-line thresholds, exceptions, or comparatively high detail and implementation guidance. Then we took a look at a sample of accounting lawsuits (and potential accounting lawsuits) to see which areas of GAAP are more likely to trigger litigation. We’ve found that in federal securities class actions alleging GAAP violations, plaintiffs tend to target principles-based, or less rules-based, areas of GAAP. Rules-based standards appear to decrease, not increase, litigation risk.
Also relating to financial reporting is the banking industry’s fair value debate. I have a study that examines whether or not measuring loans at fair value, rather than historical cost with a loan loss reserve, results in better predictions of future credit losses and bank failure. Supporters argue that loan fair values give users better information about the credit risk of a bank’s loan portfolio, and can provide an early warning of impending credit losses. Their opponents contend that loan fair values are neither reliable nor relevant because many loans are never sold. The FASB recently waded into the debate, and proposed recognizing bank loans (which account for 70 to 80 percent of assets in the banking industry) on the balance sheet at fair value. Fierce opposition forced the FASB to back away from the proposal, at least for now.
The study we conducted indicates that loan fair values, as currently disclosed in the financials, do not provide better information about credit risk than net historical costs (i.e., net of loan loss reserves). One explanation may be that banks are putting less effort into their disclosed loan fair values than recognized net historical costs.
John McInnis received his PhD from the University of Iowa and his BBA and MPA from the University of Texas. He teaches financial accounting in the MPA program. Professor McInnis has published articles in top scholarly journals including The Accounting Review, Journal of Finance, Management Science, and Journal of Accounting & Economics.
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